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Beyond Benchmark Rates: How Modern Central Banks Tighten Monetary Policy
Whether the Fed will tighten policy in 2021 is one of the most important questions for investors around the world. It’s also a question that has grown in complexity in recent years. Before the Great Financial Crisis of 2008, the question itself would have been relatively straightforward, focused on whether the Fed would hike its reference (also called benchmark or policy) rate of interest for banks.
Today, developed central banks conduct monetary policy with more tools at their disposal, which means there is also the question of whether the Fed will curtail government and corporate bond purchases and force commercial banks to have more funds kept in reserve.
Such “tightening” alternatives are closely watched by financial market professionals. After all, the Federal Reserve itself describes monetary policy in the United States as comprising “the Federal Reserve's actions and communications to promote maximum employment, stable prices, and moderate long-term interest rates—the economic goals the Congress has instructed the Federal Reserve to pursue.” This is a wide-ranging mandate, offering many options to pursue depending on economic conditions and the state of financial markets.
At the start of the pandemic in March 2020, Fed officials announced that the bank would buy $200 billion of agency mortgage-backed securities, or MBS (the financial instruments that did much to amplify the aftershocks of the 2008 crisis), and $500 billion worth of Treasuries. This was first described as a way of helping to maintain market liquidity, but the policy has switched into one of financial support: Many observers are concerned that, if the Fed were to lower the pace of bond purchases, their yields would shoot up, creating significant havoc in the markets, as happened in 2008.
In December 2020, officials said the Fed would purchase $80 billion a month in Treasuries and $40 billion a month in mortgage securities until there was “substantial progress” in the economic recovery. Between early March 2020 and late September 2021, the Fed raised the value of the assets it holds (“Reserve Bank credit”) from $4.2 trillion to $8.4 trillion, according to the Fed’s regular release of “Factors Affecting Reserve Balances,” of which the latest can be found here.
Reading the tea leaves
In a speech in late August at the all-important annual meeting of policymakers and VIPs in Jackson Hole, Wyoming, Fed Chairman Jerome H. Powell indicated that the current pace of bond-buying may slow down before the end of the year. In September, the Fed’s Open Markets Committee (FOMC) hinted in a regular statement that the Fed doesn’t believe the economy is strong enough yet to take away the monthly $120 billion purchases.
Powell also said in August that a bond-buying slowdown wouldn’t necessarily have an effect on the timing for any policy rate hike, a statement relevant for the community forecast on what the fed funds rate will be on December 31st, 2023:
For most observers and some Fed officials, the key indicator to follow, as one seeks to anticipate policy rate hikes, is what inflation will be in the US in 2021:
When economists speak of the “taper” or “tapering,” they aren’t referring to such a rate hike, however. They refer to the less blunt monetary policy action of slowing or even curtailing bond purchases: a plan to take the foot off the economic gas gradually, trimming such purchases at a pace that doesn’t have significant negative repercussions.
The Fed went through this process in 2013-2014, during a 10-month trimming campaign. The first reductions were announced in December 2013 and began the following month, with the Fed detailing cuts by $10 billion at each policy-setting meeting, divided evenly between Treasuries and mortgage bonds.
The question now is when the Fed will start the same process, a simple announcement that may upend financial markets
The Fed wrapped up all the buying in October 2014 and then lifted rates in December 2015 after having kept them steady for seven years. From that point, it slowly reduced the size of its accumulated debt portfolio as an effort at normalization, and to avoid price bubbles and economic overheating, which are typical consequences of excessively lax monetary policies.
If the past is any guide, the Fed is likely to do the same again. Here, the all-important question is the pace of such a reduction.
More monetary tools
Tapering is effectively a form of monetary policy tightening. But it’s neither the only alternative to rate hikes that the Fed has at its disposal, nor is it an American invention. While most countries rely on benchmark policy rates to set the tone for their monetary policy, there are significant and interesting exceptions, including Singapore.
There, the Monetary Authority of Singapore has conducted policy since 1981 through the Singapore dollar’s exchange rate, a more important price signal for trade-dependent Singapore than any single lending rate. MAS effectively keeps the local dollar loosely pegged (within a trading band) to a basket of foreign currencies, driving appreciation and, less frequently, depreciation against those currencies.
This monetary-policy-through-exchange-rate idea has been a success. In fact, one of the reasons why the central banks of larger countries have grown averse to hiking rates is because they tend to drive their currencies higher, which results in a net loss of competitiveness for local products in global markets—and this is especially important for those countries that aren’t forced to import most of their food and energy like Singapore must.
For example, China, like most rich countries, is quite focused on not allowing its currency to strengthen too much. China, in fact, conducts its monetary policy through yet another tool: the reserve requirement ratio (or RRR), which indicates the minimum amount of reserves that must be held by commercial banks as a percentage of their deposit liabilities.
It’s an effective tool too, as a rise in the RRR mandates banks to accumulate reserves, removing cash from the economy, and resulting in monetary policy tightening. The Fed too has resorted to using the RRR: In March 2020, as part of its emergency measures suite, it lowered the RRR to 0%, and it’s kept the policy in place since. But for how long?
However the Fed acts in coming months, the world will listen: The performance of the world’s largest economies—as well as financial markets involving stocks, bonds, commodities and derivatives—is closely correlated to the Fed’s actions and to the expectations regarding those actions.
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